Are Equity Investors too Complacent?

By Chad Karnes

Published January 25, 2013

ETFguide

A skeptic is defined as someone not convinced something is true and typically requires evidence to validate claims made by others. In the world of investing, a contrarian falls into this category. Count me as a big one.

On 12/13 we published an article entitled "3 Contrarian Signals Flashing Red Alert" found here. The premise of the article was that complacency was at extremely low levels often associated with market tops. The indicators highlighted in that article worked well in warning us of the late December short-term market top, helping us avoid the 4% decline that started the following week.

Below I take another look at these indicators for signs of excessive sentiment.

#1 - Nasdaq Fear is Nearing All-Time Lows

The VIX (CHICAGOOPTIONS:^VIX) is one tool that measures fear and complacency in the markets. When complacency is high and fear is low, the VIX is low and markets are typically toppy.

Over the last five years the VIX has never closed below the 13 level, and the majority of the time the VIX was well above the 20 level. This past week it closed below 13 for the first time since 2007 and is showing a real lack of fear in this market.

The VIX's cousin, VXN (CHICAGOOPTIONS:^VXN), measures volatility of the Nasdaq 100 (QQQ). The chart below includes some of the analysis from our latest Technical Forecast and shows the extremely low current levels of the Nasdaq 100's (NASDAQ:^NDX) volatility.

Now around 14, these volatility levels were last seen at its all time low level of fear in 2005, and, although didn't mark the exact top in the Nasdaq, was a great level to purchase volatility protection.

Volatility rose steadily from there eventually topping 75 in 2009. A similar occurrence happened near the year 2000 top with the VXN rallying to over 80 from the 30 level in under a year.

After we noticed such low fear in December, we recommended going long the VIX in the 15-16 range in our Technical Forecast and ETF Profit Strategy Newsletter. On 12/28 the VIX reached 22, a 40%+ move in two weeks, where we also suggested taking profits. ("Volatility has Spiked, Now What?" found here).

With its price nearing all time lows, the VXN is telling us that future market volatility and fear is expected to be as low as it's ever been, and that is a contrarian sign that it likely won't be anything near as calm as expected.

Although waiting for the Nasdaq's technical trend change to down is the best way to play volatility, at such low historical levels for longer term Nasdaq investors it may make sense to start buying long term volatility hedges here.

#2 - Dumb Money Remains Long

In spite of the fiasco with MF Global, The Commodity Futures Trading Commission does a great job at providing useful data for investors, especially contrarians.

The Commission provides a breakdown of the "Smart" money and the "Dumb" money based on classification between hedger or speculator. Over the long run the hedgers are usually on the winning side of the trade and the speculators the losing side.

In the face of the rally the last month (VOO), hedgers have gotten more short and support a contrarian sell signal.

On the other side of the trade, Russell 2000 (IWM) speculators (the "dumb money") are longer now than they have been in at least 4 years.

The previous time speculators were approaching this long, was in February 2012, just before a 10%+ decline in the Russell 2000 index (IWN).

We were able to use the Futures Commission's reports along with our other tools on Silver (SLV) and Gold (GLD) to help us identify a high probability opportunity in August.

On 7/29 when the "smart" money was net long and the "dumb" money was short, the media and mainstream were bearish. SLV was trading for $26.95 when we identified "SLV has broken out above its long term downtrend resistance. Ths rising red short term trendline support currently just above $26 is also a good stop loss spot and support to watch. Good risk / reward setups such as these are what we look for in our trading". When technicals align with extremes in sentiment it often provides opportunity.

Over the following month Silver and Gold took off, and exactly one month later when Silver was at $29.75 we suggested, "Silver broke down from its uptrend line and aggressive longs should have exited by now for a great profit".

#3 - Actual Complacency is Back

In another sign of complacency, the actual volatility of the market provides clues as to its future performance.

When actual volatility is low (as opposed to implied volatility that the VIX measures), complacency among participants is high. As the market's (IVV) actual volatility lowers, traders and investors "let their guards down" so to speak, and that is when bears attack.

This is supported by the historical data.

The above chart shows the S&P (SNP:^GSPC) at top with the market's actual volatility based on its daily trading range (ATR) at the bottom. When price starts to move less than 10 points each day (identified by the vertical black lines), the market (DIA) is typically close to a topping point.

This is eventually followed by periods of higher volatility (usually on the downside), at least it has 10 of the last 11 times it has occurred.

We also used this indicator in early December along with our other tools to identify the short term top. On 12/12 when the S&P was at 1428 we warned, "the 5 day ATR @ 11.86 is at levels where previous tops formed. It shows complacency and the lack of perceived risk in the market. A move below 10 would be an even stronger signal."

Two weeks later the S&P was down to 1398. The ATR is now again flirting with the lower levels again as complacency returns to extreme levels.

With the Average True Range again bottoming, the VIX making 6 year lows, and the smart money still short, we are cautious about chasing this rally. Instead we have identified key price levels that will warn us to get out of the way, if the market is again rolling over.

For more on these and other tools, the ETF Profit Strategy Newsletter combines technical, fundamental, and sentiment analysis to formulate high probability profit strategies. We publish a monthly Newsletter along with a twice weekly Technical Forecast to help our subscribers identify opportunities to put money to work and better navigate the markets.